Missed Opportunity for Schemes: Dynamic Asset Allocation Could Have Provided 3.5% More in Annual Returns, Report Says

(October 10, 2011) — Dynamic asset allocation — which aims to lower fluctuation risks and achieve returns that exceed the target benchmark of a portfolio — could have boosted returns among pension funds in the United Kingdom by 3.5% annually, new research published by Aviva Investors has shown.

In conducting its research, Aviva created two hypothetical portfolios based on the asset allocation of a UK pension. The asset allocation consisted of 71% in equities, 20% in fixed-income, 5% in property, and 4% in cash. While the first portfolio was managed dynamically over the last decade, the second was managed in a more static manner — rebalancing allocations once per year — which is more typical among UK schemes. The result: The dynamic portfolio outperformed the static one by almost 3.5% annually. The firm noted that volatility was reduced as a result of the dynamic strategy.

“I argue that static asset allocation is a poor way to time the market, while dynamic asset allocation is a better, smarter approach,” Arun Muralidhar, Chairman and Co-CIO of AlphaEngine Global Investment Solutions, told aiCIO. According to Muralidhar, a fixed allocation is “dead wrong,” the simple rationale being that investors who believe a 60/40 allocation mix is appropriate at all points in time are asserting that valuations lack merit. “With everyone panicking over Europe, equities, etc., I would say it’s more important to manage risk through dynamic asset allocation — and if you do that correctly you’ll get additional value.” Dynamic asset allocation applies regardless of location or type of institution, Muralidhar asserted. “Endowments are no different, pensions are no different, insurance companies are no different,” he said, adding that dynamic asset allocation is about good governance and good risk management.

Earlier this month, a study from the EDHEC-Risk Institute, produced as part of the Amundi ETF research chair on “Core-Satellite and ETF Investment,” found that implementation of a Dynamic Core-Satellite approach can boost portfolio returns while keeping downside risk under control. The research analyzed the performance of risk-controlled dynamic asset allocation strategies, concluding that “there is extensive evidence that investment strategies based on momentum and value are attractive for portfolio managers who seek outperformance. Momentum and value are among the most robust return drivers in the cross section of expected returns.”

The report continued: “Investors are usually willing to take on risk only if they are compensated for it with greater expected reward…Dynamic risk budgeting methodologies such as Dynamic Core-Satellite strategies are used to provide risk-controlled exposure to different asset classes. There is extensive evidence that investment strategies based on momentum and value are attractive for portfolio managers who seek outperformance.”

The research, conducted by Elie Charbit, Jean-René Giraud, Felix Goltz and Lin Tan,  claimed that exchange-traded funds — which offer both liquidity and a broad exposure to the markets to implement portfolio strategies — on sectors rather than on stocks can be used to put these strategies into effect. The study concluded that ETFs additionally facilitate the shifts — required by dynamic strategies — from core to satellite.